Remarks

Introduction
Chapter 1

Fundamentals of Futures and Options Markets, 7th Ed, Ch 1, Copyright John C. Hull 2010

All information is available on Moodle Lectures & Tutorials: I present the theory, please prepare! We discuss the end-of-chapter questions & problems, please prepare! Textbook: Hull, 2011, Fundamentals of Futures and Options Markets, 7th edition, Pearson/Prentice Hall Exam Use one page A4 with formulas & non-progr. calculator

Topics

The Nature of Derivatives

Derivatives: Introduction

Hedging, arbitrage, speculation Markets, history, how to use/price? Markets, hedging and pricing issues Binomial trees vs. Black/Scholes model Greeks: option sensitivities Option strategies, other issues
3

Futures/Forwards

Options

A derivative is an instrument whose value depends on the values of other more basic underlying variables

Fundamentals of Futures and Options Markets, 7th Ed, Ch 1, Copyright John C. Hull 2010

Examples of Derivatives

Ways Derivatives are Used

Futures Contracts Forward Contracts Swaps Options

To hedge risks To speculate (take a view on the future direction of the market) To lock in an arbitrage profit To change the nature of a liability To change the nature of an investment without incurring the costs of selling one portfolio and buying another
6

Fundamentals of Futures and Options Markets, 7th Ed, Ch 1, Copyright John C. Hull 2010

Fundamentals of Futures and Options Markets, 7th Ed, Ch 1, Copyright John C. Hull 2010

Futures Contracts

Exchanges Trading Futures

A futures contract is an agreement to buy or sell an asset at a certain time in the future for a certain price By contrast in a spot contract there is an agreement to buy or sell the asset immediately (or within a very short period of time)

CBOT and CME (now CME Group) Intercontinental Exchange NYSE Euronext Eurex BM&FBovespa (Sao Paulo, Brazil) and many more (see list at end of book)

Fundamentals of Futures and Options Markets, 7th Ed, Ch 1, Copyright John C. Hull 2010

Fundamentals of Futures and Options Markets, 7th Ed, Ch 1, Copyright John C. Hull 2010

Futures Price

Electronic Trading

The futures prices for a particular contract is the price at which you agree to buy or sell It is determined by supply and demand in the same way as a spot price

Traditionally futures contracts have been traded using the open outcry system where traders physically meet on the floor of the exchange Increasingly this is being replaced by electronic trading where a computer matches buyers and sellers

Fundamentals of Futures and Options Markets, 7th Ed, Ch 1, Copyright John C. Hull 2010

Fundamentals of Futures and Options Markets, 7th Ed, Ch 1, Copyright John C. Hull 2010

10

Examples of Futures Contracts

Agreement to: buy 100 oz. of gold @ US$1050/oz. in December sell 62,500 @ 1.5500 US$/ in March sell 1,000 bbl. of oil @ US$75/bbl. in April
Fundamentals of Futures and Options Markets, 7th Ed, Ch 1, Copyright John C. Hull 2010

Terminology

The party that has agreed to buy has a long position The party that has agreed to sell has a short position

11

Fundamentals of Futures and Options Markets, 7th Ed, Ch 1, Copyright John C. Hull 2010

12

Example

Over-the Counter Markets

January: an investor enters into a long futures contract to buy 100 oz of gold @ $1050 in April April: the price of gold $1065 per oz What is the investors profit?

The over-the counter market is an important alternative to exchanges It is a telephone and computer-linked network of dealers who do not physically meet Trades are usually between financial institutions, corporate treasurers, and fund managers
14

Fundamentals of Futures and Options Markets, 7th Ed, Ch 1, Copyright John C. Hull 2010

13

Fundamentals of Futures and Options Markets, 7th Ed, Ch 1, Copyright John C. Hull 2010

Size of OTC and Exchange Markets

(Figure 1.2, Page 4)

Forward Contracts

Forward contracts are similar to futures except that they trade in the over-thecounter market Forward contracts are popular on currencies and interest rates

Source: Bank for International Settlements. Chart shows total principal amounts for OTC market and value of underlying assets for exchange market
Fundamentals of Futures and Options Markets, 7th Ed, Ch 1, Copyright John C. Hull 2010

15

Fundamentals of Futures and Options Markets, 7th Ed, Ch 1, Copyright John C. Hull 2010

16

Options
A call option is an option to buy a certain asset by a certain date for a certain price (the strike price) A put option is an option to sell a certain asset by a certain date for a certain price (the strike price)

American vs European Options

An American option can be exercised at any time during its life A European option can be exercised only at maturity

Fundamentals of Futures and Options Markets, 7th Ed, Ch 1, Copyright John C. Hull 2010

17

Fundamentals of Futures and Options Markets, 7th Ed, Ch 1, Copyright John C. Hull 2010

18

Google Option Prices (July 17, 2009; Stock Price=430.25); See page 6
Calls Sept 2009 54.60 38.30 24.80 14.45 7.45 3.40 Puts Sept 2009 4.40 8.30 14.70 24.25 37.20 53.10

Exchanges Trading Options

Strike price ($) 380 400 420 440 460 480

Aug 2009 51.55 34.10 19.60 9.25 3.55 1.12

Dec 2009 65.00 51.25 39.05 28.75 20.40 13.75

Aug 2009 1.52 4.05 9.55 19.20 33.50 51.10

Dec 2009 15.00 21.15 28.70 38.35 49.90 63.40

Chicago Board Options Exchange International Securities Exchange NYSE Euronext Eurex (Europe) and many more (see list at end of book)

Fundamentals of Futures and Options Markets, 7th Ed, Ch 1, Copyright John C. Hull 2010

19

Fundamentals of Futures and Options Markets, 7th Ed, Ch 1, Copyright John C. Hull 2010

20

Options vs Futures/Forwards

Hedging Examples (Example 1.1 and 1.2,

page 11)

A futures/forward contract gives the holder the obligation to buy or sell at a certain price An option gives the holder the right to buy or sell at a certain price

A US company will pay 10 million for imports from Britain in 3 months and decides to hedge using a long position in a forward contract An investor owns 1,000 Microsoft shares currently worth $28 per share. A two-month put with a strike price of $27.50 costs $1. The investor decides to hedge by buying 10 contracts

Fundamentals of Futures and Options Markets, 7th Ed, Ch 1, Copyright John C. Hull 2010

21

Fundamentals of Futures and Options Markets, 7th Ed, Ch 1, Copyright John C. Hull 2010

22

Value of Microsoft Shares with and without Hedging (Fig 1.4, page 12)

1. Gold: An Arbitrage Opportunity?

Suppose that: The spot price of gold is US$1000 The quoted 1-year futures price of gold is US$1100 The 1-year US$ interest rate is 5% per annum No income or storage costs for gold Is there an arbitrage opportunity?
24

Fundamentals of Futures and Options Markets, 7th Ed, Ch 1, Copyright John C. Hull 2010

23

Fundamentals of Futures and Options Markets, 7th Ed, Ch 1, Copyright John C. Hull 2010

2. Gold: Another Arbitrage Opportunity?

The Futures Price of Gold

If the spot price of gold is S & the futures price is for a contract deliverable in T years is F, then F = S (1+r )T where r is the 1-year (domestic currency) riskfree rate of interest. In our examples, S=1000, T=1, and r=0.05 so that F = 1000(1+0.05) = 1050
25
Fundamentals of Futures and Options Markets, 7th Ed, Ch 1, Copyright John C. Hull 2010

Suppose that: The spot price of gold is US$1000 The quoted 1-year futures price of gold is US$990 The 1-year US$ interest rate is 5% per annum No income or storage costs for gold Is there an arbitrage opportunity?

Fundamentals of Futures and Options Markets, 7th Ed, Ch 1, Copyright John C. Hull 2010

26

1. Oil: An Arbitrage Opportunity?

Suppose that: The spot price of oil is US$70 The quoted 1-year futures price of oil is US$80 The 1-year US$ interest rate is 5% per annum The storage costs of oil are 2% per annum Is there an arbitrage opportunity?
Fundamentals of Futures and Options Markets, 7th Ed, Ch 1, Copyright John C. Hull 2010

2. Oil: Another Arbitrage Opportunity?

27

Suppose that: The spot price of oil is US$70 The quoted 1-year futures price of oil is US$65 The 1-year US$ interest rate is 5% per annum The storage costs of oil are 2% per annum Is there an arbitrage opportunity?
28

Fundamentals of Futures and Options Markets, 7th Ed, Ch 1, Copyright John C. Hull 2010

Futures Contracts

Mechanics of Futures Markets

Chapter 2

Available on a wide range of underlyings Exchange traded Specifications need to be defined:

What can be delivered, Where it can be delivered, & When it can be delivered

Settled daily
30

Fundamentals of Futures and Options Markets, 7th Ed, Ch 2, Copyright John C. Hull 2010

29

Fundamentals of Futures and Options Markets, 7th Ed, Ch 2, Copyright John C. Hull 2010

Margins

Example of a Futures Trade

A margin is cash or marketable securities deposited by an investor with his or her broker The balance in the margin account is adjusted to reflect daily settlement Margins minimize the possibility of a loss through a default on a contract
31

An investor takes a long position in 2 December gold futures contracts on June 5

contract size is 100 oz. futures price is US$900 margin requirement is US$2,000/contract (US$4,000 in total) maintenance margin is US$1,500/contract (US$3,000 in total)
32

Fundamentals of Futures and Options Markets, 7th Ed, Ch 2, Copyright John C. Hull 2010

Fundamentals of Futures and Options Markets, 7th Ed, Ch 2, Copyright John C. Hull 2010

A Possible Outcome
Table 2.1, Page 27
Daily Gain (Loss) (US$) Cumulative Gain (Loss) (US$) Margin Account Margin Balance Call (US$) (US$) 4,000 (600) . . . (420) . . . (1,140) . . . 260 (600) . . . (1,340) . . . (2,600) . . . (1,540) 3,400 . . . 0 . . . Futures Price (US$) 900.00 5-Jun 897.00 . . . . . . 13-Jun 893.30 . . . . . . 19-Jun 887.00 . . . . . . 26-Jun 892.30

Other Key Points About Futures

Day

They are settled daily Closing out a futures position involves entering into an offsetting trade Most contracts are closed out before maturity

2,660 + 1,340 = 4,000 . . . . . 2,740 + 1,260 = 4,000 . . . . . . 5,060 0

Fundamentals of Futures and Options Markets, 7th Ed, Ch 2, Copyright John C. Hull 2010

33

Fundamentals of Futures and Options Markets, 7th Ed, Ch 2, Copyright John C. Hull 2010

34

Collateralization in OTC Markets

Delivery

It is becoming increasingly common for contracts to be collateralized in OTC markets Counterparties then post margin with each other to reflect changes in the value of the contract Regulators are now insisting that clearinghouses (similar to those used for futures) be used for some OTC contracts
35

If a futures contract is not closed out before maturity, it is usually settled by delivering the assets underlying the contract. When there are alternatives about what is delivered, where it is delivered, and when it is delivered, the party with the short position chooses. A few contracts (for example, those on stock indices and Eurodollars) are settled in cash When there is cash settlement contracts are traded until a predetermined time. All are then declared to be closed out.

Fundamentals of Futures and Options Markets, 7th Ed, Ch 2, Copyright John C. Hull 2010

Fundamentals of Futures and Options Markets, 7th Ed, Ch 2, Copyright John C. Hull 2010

36

Some Terminology

Convergence of Futures to Spot

(Figure 2.1, page 25)

Open interest: the total number of contracts outstanding. This equals to number of long positions or number of short positions Settlement price: the price just before the final bell each day. This is used for the daily settlement process Volume of trading: the number of trades in 1 day

Futures Price Spot Price

Spot Price Futures Price

Time

Time

(a)
Fundamentals of Futures and Options Markets, 7th Ed, Ch 2, Copyright John C. Hull 2010

(b)
38

37

Fundamentals of Futures and Options Markets, 7th Ed, Ch 2, Copyright John C. Hull 2010

Forward Contracts

Profit from a Long Forward or Futures Position

Profit

A forward contract is an OTC agreement to buy or sell an asset at a certain time in the future for a certain price There is no daily settlement (but collateral may have to be posted). At the end of the life of the contract one party buys the asset for the agreed price from the other party
39

Price of Underlying at Maturity

Fundamentals of Futures and Options Markets, 7th Ed, Ch 2, Copyright John C. Hull 2010

Fundamentals of Futures and Options Markets, 7th Ed, Ch 2, Copyright John C. Hull 2010

40

Profit from a Short Forward or Futures Position

Profit

Forward Contracts vs Futures Contracts (Table 2.3, page 40)

Forward Private contract between two parties Not standardized Usually one specified delivery date Futures Traded on an exchange Standardized Range of delivery dates Settled daily Usually closed out prior to maturity Virtually no credit risk

Price of Underlying at Maturity

Settled at end of contract Delivery or final settlement usual Some credit risk

Fundamentals of Futures and Options Markets, 7th Ed, Ch 2, Copyright John C. Hull 2010

41

Fundamentals of Futures and Options Markets, 7th Ed, Ch 2, Copyright John C. Hull 2010

42

Foreign Exchange Quotes

Futures exchange rates are quoted as the number of USD per unit of the foreign currency Forward exchange rates are quoted in the same way as spot exchange rates. This means that GBP, EUR, AUD, and NZD are USD per unit of foreign currency. Other currencies (e.g., CAD and JPY) are quoted as units of the foreign currency per USD.
43

Mechanics of Options Markets

Chapter 9

Fundamentals of Futures and Options Markets, 7th Ed, Ch 2, Copyright John C. Hull 2010

Fundamentals of Futures and Options Markets, 7th Ed, Ch 9, Copyright John C. Hull 2010

44

Types of Options

Option Positions
Long call Long put Short call Short put

A call is an option to buy A put is an option to sell A European option can be exercised only at the end of its life An American option can be exercised at any time

Fundamentals of Futures and Options Markets, 7th Ed, Ch 9, Copyright John C. Hull 2010

45

Fundamentals of Futures and Options Markets, 7th Ed, Ch 9, Copyright John C. Hull 2010

46

Long Call
(Figure 9.1, Page 207)

Short Call
(Figure 9.3, page 208)

Profit from buying one European call option: option price = $5, strike price = $100. 30 Profit ($) 20 10 70 0 -5 80 90 100 Terminal stock price ($) 110 120 130
47

Profit from writing one European call option: option price = $5, strike price = $100 Profit ($) 5 0 -10 -20 -30
Fundamentals of Futures and Options Markets, 7th Ed, Ch 9, Copyright John C. Hull 2010

110 120 130 70 80 90 100 Terminal stock price ($)

Fundamentals of Futures and Options Markets, 7th Ed, Ch 9, Copyright John C. Hull 2010

48

Long Put
(Figure 9.2, page 208)

Short Put
(Figure 9.4, page 209)

Profit from buying a European put option: option price = $7, strike price = $70 30 Profit ($)

Profit from writing a European put option: option price = $7, strike price = $70 Profit ($) 7 0 40 50 60 70 80 Terminal stock price ($) 90 100

20 10 0 -7 40 50 60 70 80 Terminal stock price ($) 90 100

-10 -20 -30

49
Fundamentals of Futures and Options Markets, 7th Ed, Ch 9, Copyright John C. Hull 2010

Fundamentals of Futures and Options Markets, 7th Ed, Ch 9, Copyright John C. Hull 2010

50

Payoffs from Options

What is the Option Position in Each Case?

Assets Underlying Exchange-Traded Options

Page 210-211

K = Strike price, ST = Price of asset at maturity Payoff Payoff K K Payoff K ST Payoff K ST ST

51
Fundamentals of Futures and Options Markets, 7th Ed, Ch 9, Copyright John C. Hull 2010

ST

Stocks Foreign Currency Stock Indices Futures

Fundamentals of Futures and Options Markets, 7th Ed, Ch 9, Copyright John C. Hull 2010

52

Specification of Exchange-Traded Options

Terminology
Moneyness : At-the-money option In-the-money option Out-of-the-money option

Expiration date Strike price European or American Call or Put (option class)

Fundamentals of Futures and Options Markets, 7th Ed, Ch 9, Copyright John C. Hull 2010

53

Fundamentals of Futures and Options Markets, 7th Ed, Ch 9, Copyright John C. Hull 2010

54

Executive Stock Options

Option issued by a company to executives When the option is exercised the company issues more stock Usually at-the-money when issued

Hedging Strategies Using Futures

Chapter 3

Fundamentals of Futures and Options Markets, 7th Ed, Ch 9, Copyright John C. Hull 2010

55

Fundamentals of Futures and Options Markets, 7th Ed, Ch3, Copyright John C. Hull 2010

56

Long & Short Hedges

Arguments in Favor of Hedging

A long futures hedge is appropriate when you know you will purchase an asset in the future and want to lock in the price A short futures hedge is appropriate when you know you will sell an asset in the future & want to lock in the price

Companies should focus on the main business they are in and take steps to minimize risks arising from interest rates, exchange rates, and other market variables

Fundamentals of Futures and Options Markets, 7th Ed, Ch3, Copyright John C. Hull 2010

57

Fundamentals of Futures and Options Markets, 7th Ed, Ch3, Copyright John C. Hull 2010

58

Arguments against Hedging

Convergence of Futures to Spot

(Hedge initiated at time t1 and closed out at time t2)

Shareholders are usually well diversified and can make their own hedging decisions It may increase risk to hedge when competitors do not Explaining a situation where there is a loss on the hedge and a gain on the underlying can be difficult
59

Futures Price

Spot Price
Time t1 t2 60

Fundamentals of Futures and Options Markets, 7th Ed, Ch3, Copyright John C. Hull 2010

Fundamentals of Futures and Options Markets, 7th Ed, Ch3, Copyright John C. Hull 2010

10

Basis Risk

Long Hedge

Basis is the difference between spot & futures Basis risk arises because of the uncertainty about the basis when the hedge is closed out

Fundamentals of Futures and Options Markets, 7th Ed, Ch3, Copyright John C. Hull 2010

Suppose that F1 : Initial Futures Price F2 : Final Futures Price S2 : Final Asset Price You hedge the future purchase of an asset by entering into a long futures contract Cost of Asset=S2 (F2 F1) = F1 + Basis
62

61

Fundamentals of Futures and Options Markets, 7th Ed, Ch3, Copyright John C. Hull 2010

Short Hedge

Choice of Contract

Suppose that F1 : Initial Futures Price F2 : Final Futures Price S2 : Final Asset Price You hedge the future sale of an asset by entering into a short futures contract Price Realized=S2+ (F1 F2) = F1 + Basis
63

Choose a delivery month that is as close as possible to, but later than, the end of the life of the hedge When there is no futures contract on the asset being hedged, choose the contract whose futures price is most highly correlated with the asset price. There are then 2 components to basis
64

Fundamentals of Futures and Options Markets, 7th Ed, Ch3, Copyright John C. Hull 2010

Fundamentals of Futures and Options Markets, 7th Ed, Ch3, Copyright John C. Hull 2010

Optimal Hedge Ratio

Proportion of the exposure that should optimally be hedged is
h= S F

Hedging Using Index Futures

(Page 63)

where S is the standard deviation of S, the change in the spot price during the hedging period, F is the standard deviation of F, the change in the futures price during the hedging period is the coefficient of correlation between S and F.
Fundamentals of Futures and Options Markets, 7th Ed, Ch3, Copyright John C. Hull 2010

To hedge the risk in a portfolio the number of contracts that should be shorted is V A VF where VA is the current value of the portfolio, is its beta, and VF is the current value of one futures (=futures price times contract size)
65
Fundamentals of Futures and Options Markets, 7th Ed, Ch3, Copyright John C. Hull 2010

66

11

Reasons for Hedging an Equity Portfolio

Example
Futures price of S&P 500 is 1,000 Size of portfolio is $5 million Beta of portfolio is 1.5 One contract is on $250 times the index What position in futures contracts on the S&P 500 is necessary to hedge the portfolio?

Desire to be out of the market for a short period of time. (Hedging may be cheaper than selling the portfolio and buying it back.) Desire to hedge systematic risk

Fundamentals of Futures and Options Markets, 7th Ed, Ch3, Copyright John C. Hull 2010

67

Fundamentals of Futures and Options Markets, 7th Ed, Ch3, Copyright John C. Hull 2010

68

Changing Beta

Stock Picking

What position is necessary to reduce the beta of the portfolio to 0.75? What position is necessary to increase the beta of the portfolio to 2.0?

If you think you can pick stocks that will outperform the market, futures contract can be used to hedge the market risk If you are right, you will make money whether the market goes up or down

Fundamentals of Futures and Options Markets, 7th Ed, Ch3, Copyright John C. Hull 2010

69

Fundamentals of Futures and Options Markets, 7th Ed, Ch3, Copyright John C. Hull 2010

70

Rolling The Hedge Forward

We can use a series of futures contracts to increase the life of a hedge Each time we switch from 1 futures contract to another we incur a type of basis risk

Determination of Forward and Futures Prices

Chapter 5

Fundamentals of Futures and Options Markets, 7th Ed, Ch3, Copyright John C. Hull 2010

71

Fundamentals of Futures and Options Markets, 7th Ed, Ch 5, Copyright John C. Hull 2010

72

12

Consumption vs Investment Assets

Short Selling (Page 104-105)

Investment assets are assets held by significant numbers of people purely for investment purposes (Examples: gold, silver) Consumption assets are assets held primarily for consumption (Examples: copper, oil)

Short selling involves selling securities you do not own Your broker borrows the securities from another client and sells them in the market in the usual way

Fundamentals of Futures and Options Markets, 7th Ed, Ch 5, Copyright John C. Hull 2010

73

Fundamentals of Futures and Options Markets, 7th Ed, Ch 5, Copyright John C. Hull 2010

74

Short Selling
(continued)

Notation
S0: Spot price today F0: Futures or forward price today T: Time until delivery date r: Risk-free interest rate for maturity T

At some stage you must buy the securities back so they can be replaced in the account of the client You must pay dividends and other benefits the owner of the securities receives

Fundamentals of Futures and Options Markets, 7th Ed, Ch 5, Copyright John C. Hull 2010

75

Fundamentals of Futures and Options Markets, 7th Ed, Ch 5, Copyright John C. Hull 2010

76

1. Gold: An Arbitrage Opportunity?

2. Gold: Another Arbitrage Opportunity?

Suppose that: The spot price of gold is US$1000 The quoted 1-year futures price of gold is US$1100 The 1-year US$ interest rate is 5% per annum No income or storage costs for gold Is there an arbitrage opportunity?
77

Suppose that: The spot price of gold is US$1000 The quoted 1-year futures price of gold is US$990 The 1-year US$ interest rate is 5% per annum No income or storage costs for gold Is there an arbitrage opportunity?
78

Fundamentals of Futures and Options Markets, 7th Ed, Ch 5, Copyright John C. Hull 2010

Fundamentals of Futures and Options Markets, 7th Ed, Ch 5, Copyright John C. Hull 2010

13

The Futures Price of Gold

If the spot price of gold is S & the futures price is for a contract deliverable in T years is F, then F = S (1+r )T where r is the 1-year (domestic currency) riskfree rate of interest. In our examples, S=1000, T=1, and r=0.05 so that F = 1000(1+0.05) = 1050
Fundamentals of Futures and Options Markets, 7th Ed, Ch 5, Copyright John C. Hull 2010

When Interest Rates are Measured with Continuous Compounding

F0 = S0erT
This equation relates the forward price and the spot price for any investment asset that provides no income and has no storage costs
Fundamentals of Futures and Options Markets, 7th Ed, Ch 5, Copyright John C. Hull 2010

79

80

When an Investment Asset Provides a Known Dollar Income

(page 110, equation 5.2)

When an Investment Asset Provides a Known Yield

(Page 111, equation 5.3)

F0 = (S0 I )erT where I is the present value of the income during life of forward contract

F0 = S0 e(rq )T
where q is the average yield during the life of the contract (expressed with continuous compounding)

Fundamentals of Futures and Options Markets, 7th Ed, Ch 5, Copyright John C. Hull 2010

81

Fundamentals of Futures and Options Markets, 7th Ed, Ch 5, Copyright John C. Hull 2010

82

Valuing a Forward Contract

Page 112

Stock Index (Page 115)

Suppose that K is delivery price in a forward contract & F0 is forward price that would apply to the contract today The value of a long forward contract, , is = (F0 K )erT Similarly, the value of a short forward contract is (K F0 )erT
83

Can be viewed as an investment asset paying a dividend yield The futures price and spot price relationship is therefore

F0 = S0 e(rq )T
where q is the dividend yield on the portfolio represented by the index during life of contract
Fundamentals of Futures and Options Markets, 7th Ed, Ch 5, Copyright John C. Hull 2010

Fundamentals of Futures and Options Markets, 7th Ed, Ch 5, Copyright John C. Hull 2010

84

14

Stock Index
(continued)

Index Arbitrage

For the formula to be true it is important that the index represent an investment asset In other words, changes in the index must correspond to changes in the value of a tradable portfolio The Nikkei index viewed as a dollar number does not represent an investment asset
85

When F0 > S0e(r-q)T an arbitrageur buys the stocks underlying the index and sells futures When F0 < S0e(r-q)T an arbitrageur buys futures and shorts or sells the stocks underlying the index

Fundamentals of Futures and Options Markets, 7th Ed, Ch 5, Copyright John C. Hull 2010

Fundamentals of Futures and Options Markets, 7th Ed, Ch 5, Copyright John C. Hull 2010

86

Index Arbitrage
(continued)

Futures and Forwards on Currencies (Page 116-120)

Index arbitrage involves simultaneous trades in futures and many different stocks Very often a computer is used to generate the trades

A foreign currency is analogous to a security providing a dividend yield The continuous dividend yield is the foreign risk-free interest rate It follows that if rf is the foreign risk-free interest rate

F0 = S 0 e
Fundamentals of Futures and Options Markets, 7th Ed, Ch 5, Copyright John C. Hull 2010

( r rf ) T

87

Fundamentals of Futures and Options Markets, 7th Ed, Ch 5, Copyright John C. Hull 2010

88

Futures on Consumption Assets

(Page 122)

F0 S0 e(r+u )T
where u is the storage cost per unit time as a percent of the asset value. Alternatively,

F0 (S0+U )erT
where U is the present value of the storage costs.
Fundamentals of Futures and Options Markets, 7th Ed, Ch 5, Copyright John C. Hull 2010

89

15